The Four Pillars of GameStop’s Stock Craziness and what it tells us about the Financial System
When I wrote “The Financial Advice One Pager” I promised myself a follow-up to dive into the things that make “the market” a.k.a. Wall Street a suboptimal place for participating in real world capitalism.
I postponed this article until now. Then GameStop happened.
Casus GameStop
Here’s a good explainer to catch up.
It’s not the first stunner. Since the start of the pandemic we’ve seen ‘market inefficiencies’ like Zoom, Signal Advance or most similarly Hertz.
But the case GameStop is in this magnitude unprecedented. I think it rests on four pillars:
I: The ‘David vs. Goliath’ story
The prevalent angle in media. Who doesn’t love a good ‘underdog wins’ story?
It’s the perfect setup: On the one side are old, rich incumbents, a stand-in for the current capitalist system that brought us the Financial Crisis while getting bailed out.
On the other side is a loose collection of anonymous strangers, often millennials or younger, with no etiquette, brought together by an internet forum and their common appetite to gamble with money.
This is how it feels to be in this subreddit:
Reading Wall Street Bets feels like the discussion at a middle school cafeteria table circa 2000. Redditors on Wall Street Bets (who refer to themselves affectionately as “autists” or “retards”) encourage one another to have “diamond hands” (💎 🤲), the will to stay strong and not sell a stock when things are going poorly. Contrast this with the “paper hands” (🧻 🤲) of those who are weak-willed and sell a stock based on market sentiment. Companies are headed “to the moon” (🚀). Bears are not mentioned without the adjective “gay” (🌈 🐻). Self-deprecating cuckold references to “my wife’s boyfriend” abound.
Big bad hedge funds (remember millennials witnessed three life-changing financial meltdowns already) are the enemies that rigged the system against them in the past.
After all, the subreddit is the web-scaled version of idea dinners.
From an inside rigged system to an outside rigged system.
One could also see a revival of the penny stock firms like Stratford-Oakmont with the difference that the main beneficiary isn’t one company, it’s one forum (which is a little bit more democratised).
Make no mistake, we’re just in round one of this fight. Hedge funds are already lining up at the SEC, asking to monitor Social Media groups. Circuit breakers are being discussed.
Following the money flows paints a different picture: “Smart” money is short and long. It’s certainly one hedge fund versus the other.
But never underestimate a “Us vs. Them”-story in building momentum.
II: The ‘Story’ story
The narrative around a company matters much more than the underlying fundamentals right now. Questions like “does the company make any money?” sound almost silly.
In part Covid is to blame, since we value companies now more about the far future than the present — with stores closed for lots of companies there is no revenue on which to base analysis on.
In greater parts this is a long running trend. Since the Great Financial Crisis so-called Growth stocks outperformed Value stocks by a wide margin.
But past growth stocks grew into their lofty valuations time and time again. Investors looked into the future, yes, but that future would come true more often than not.
Now valuations seem to be decoupled completely from reality.
Value has become a dirty word. Traditional fund managers used to identify a cheap stock and buy it in the hope that it would gain in value. Nowadays cheapness is a turn off rather than a turn on. Expensive stocks get more expensive as they attract more flows, and cheap stocks are shunned as losers rather than diamonds waiting to be discovered.
To use language of the RobinHood generation:
It’s as if suddenly everyone woke up and realised that we don’t need to play by the unofficial rules (to value stocks based on the fundamental performance of the company).
sam lessin characterised this development with “The Mob”:
I can see why the Crypto scene may react salty: They’re the original inventors of ‘value without underlying assets’. In a sense it’s more pure if the underlying asset is zero rather than very small. (Which reminds me of the genius pre-revenue scene from Silicon Valley.)
III: The ‘Turnaround’ story
As much as I marvel at the comment “We made our own trickle down economy”, examples like this thread are missing the grain of truth, the underlying story that is important, even for Reddit gamblers:
This is an unheard of valuation for a growth company to be trading at a discount.
The user DeepFuckingValue held option calls worth of $50k since 2019. In this video he makes his case about “strong fundamentals”.
The WSB forum grew this catalyst with a personal obsession of Ryan Cohen who invested late last year.
It’s the same story for other narrative-driven stocks. Tesla, Apple or Peloton are religious cults. No, actually they are more than that because of the financial aspect.
Superfans who bought Tesla stock, made sure it got cheap liquidity while getting rich themselves (to spend it on the next car, from Tesla.)
The gambling changes real-life fundamentals — the company gets money for “free” by issuing more shares which then can be used for M&A etc..
Given almost all of Tesla’s competitors are publicly listed, it could be an unfriendly takeover that solves Elon’s nights sleeping under the desk and productions issues.
That’s why I called it a self-fulfilling prophecy.
Read more about this phenomena in Peak Reflexivity.
When I talk to Tesla shareholders, they are aware that we’re in a bubble, but are also eager to justify why the company is different and that there is room to grow because nobody else is innovative enough.
Although in the real world probably Toyota influenced technological innovation more than Tesla. Oh, the irony.
What I’m saying is this: Even the most unrealistic stock price is rooted on a good story-telling basement.
IV: The ‘Technicals’ story
Regardless of what sparked the move, it has become a flywheel by now. That mainstream media outlets report the case in its absurdity throws fuel in the fire — just like with Bitcoin in 2017.
Matt Levine explains the technical term short squeeze as usual pretty straightforward.
When the stock goes up a lot, short sellers start feeling “squeezed”: Their borrow costs go up, they have to post more collateral, and lenders might ask for their stock back. Some short sellers might have to capitulate, and they will close their positions by buying back stock. There is a feedback loop: The stock goes up, short sellers give up, they buy stock to surrender, and their buying pushes the stock up more.
And if that’s still to complicated, here’s the Reddit version of short squeezing:
Ranjan Roy has a wonderful story to tell about gamma.
The endgame in the case of GameStop seems to be the legendary Infinity Squeeze as happened to VW.
Where it gets really absurd is when you take into account that the parent company of the hedge fund in trouble (Melvin Capital) buys order flow data from Robinhood. At this volatility smart money is surely involved. The SEC certainly needs to investigate this.
Would an infinity squeeze be the end of the story? Well, who knows where it goes from here.
As discussed before: Money searches for the next hype-train. I bet that 95% of all traders who bought Signal Advance after the Musk tweet aren’t actually dumb — instead they are (correctly) assuming others will buy the stock. It’s all a Keynesian beauty contest.
The Bigger Picture
Now think about all that when we zoom out and look at the problem that the first stock market in history was trying to solve:
To lessen the risk of a lost ship ruining their fortunes, ship owners had long been in the practice of seeking investors who would put up money for the voyage — outfitting the ship and crew in return for a percentage of the proceeds if the voyage was successful. These early limited liability companies often lasted for only a single voyage. They were then dissolved, and a new one was created for the next voyage. Investors spread their risk by investing in several different ventures at the same time, thereby playing the odds against all of them ending in disaster.
[…] the first stock exchange thrived for decades without a single stock being traded
This is what I would call a stark contrast to this:
From unbundling risks to (algorithmically) jumping on leveraged hype trains of meme stocks to net 1,000% profit in a couple of days — oh wait, it’s 10x without using leverage.
Same with voting rights and dividends. They were an incremental part of what stock was supposed to be — yet today’s equity markets disregard them as historical baggage.
The reason why stocks are called equity ownership instruments comes from history. Before the 1900s, all stocks paid dividends, and there was a definitive profit-sharing agreement between the shareholders and the companies they owned. Capital gains was never meant to be the primary or only way for investors to get their money back. Stocks came into existence because of dividends, not capital gains.
Today, a share of Google can cost $1200, but Google states in writing; they don’t pay dividends, there are no voting rights, and the par value of GOOG is only $0.001. So, if you own a share of Google, you won’t receive any money from the business, you can’t vote, and Google is only obligated to pay you $0.001 for that $1200 share.
Think about all the collective lost productivity that was spent the last week just to understand what is going on, let alone debate it. (Some skipped the understanding part and jumped to moral conclusions — with predictable outcomes in terms of quality.)
Think about the brain power our economy loses each year when the smartest minds choose a career in finance because it pays well.
I’m not judging them. Neither actor inside the system is wrong. Not the “suits” and not the “retail bro’s” and not suits disguised as retail bro’s. What’s wrong is the system and its incentives.
Even if there were a legal basis on which to prosecute Reddit members (there is none), why would one do that? All they did was to expose flaws in the current system.
At least the whole affair ripped apart the curtain: When you thought you will make money on the stock market because you know the future of a given company or sector, well, this story shows the many pitfalls.
A prediction is whether company X beats the earnings forecast or not. But stocks are a speculation how the company will be perceived by other potential buyers/sellers. More psychology and story-telling than not. What’s the financial instrument to capitalise on getting the quarterly estimate right? Certainly not Wall Street.
I would love to walk away from the stock market because of that — but as I said we have no alternative at the moment.
In an economy where wages stagnate while company profits soar, you need an instrument to let common people participate in companies, otherwise they will revolt sooner or later.
It would be wrong to use the shown silliness of the financial industry as reason to turn your back to them. You can do that with the gambling / casino industry, but not with “Mr. Market”. Even it it doesn’t look this way, Main Street and Wall Street are deeply intertwined. Shenanigans on one side do affect the other party.
I guess a capitalist society actually needs more participation: Every company should allow employees to be paid (partially) in stock options.
The participation part of equity is good, check. Maybe it should be tight to fundamentals rather than psychology, though.
What I would really love is an investment instrument in companies that is subordinated to fundamentals. Maybe like corporate bonds but the coupon is the rate of return on equity. So every year the holder would receive a share of corporate profits (if there are any in that given period).
Sometimes I’m wondering if all the value companies out there ever thought about leaving the stock market and start selling a piece of their earnings or revenue instead.
Leave the stock market and all its volatile psychology to companies who haven’t made a dime (yet).
Astronomical gains in hours like seen today would be impossible. Financial engineering like seen today would be impossible.
That’s why such a proposal is probably DOA.
But heck, when we’re back in systemic risk territory that could take down the whole market because one company got hyped, like different brokers argue, then it seems like our financial system isn’t particularly robust. Moderate growth would be a better outcome for everyone in the longterm.
